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13 June 2024 Financial Analysts Journal Volume 80, Issue 3

Nonlinear Factor Returns in the US Equity Market

  1. Roger G. Clarke
  2. Harindra de Silva, CFA
  3. Steven Thorley, CFA
Using 1964–2023 data for the largest 1,000 US stocks, this study analyzes nonlinear return-to-characteristic relationships for five factors: value, momentum, small size, low beta, and profitability. Larger information ratios are a key finding.
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Abstract

We examine nonlinear return-to characteristic relationships for five equity market factors: value, momentum, small size, low beta, and profitability. Our study employs monthly returns and characteristics for the largest one thousand US stocks from 1964 to 2023 with a focus on average active returns over the last 20 years. Beyond simplicity in modeling the return-generating process, we find no reason to assume a linear relationship between characteristics and security returns. Allowance for nonlinearity leads to increases in information ratios for factor portfolios neutralized with respect to nonlinear exposure to the other factors.

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